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December 27, 2012

For Bonds in 2013, Many Unhappy Returns: Fixed Income Analysts

The fiscal cliff, an accommodative Fed and slow economy will conspire to push yields down, say analysts with Loomis Sayles, LPL and more

Fixed income investors who liked the uncertain bond market climate in 2012 will also like it in 2013 because chances are it will remain very much the same, thanks to the fiscal cliff, an accommodative Federal Reserve and slow economic growth. What will change, though, are bond returns–and there, investors are almost certain to be disappointed.

“We expect the global thirst for yield to remain intact during 2013. However, investors were treated to outstanding bond returns in 2012 that are unlikely to be repeated in 2013,” writes Tom Fahey, associate director of macro strategies for Loomis Sayles, in a fixed income outlook for the new year.

The math of bond returns “just gets harder and harder” as yields keep steadily declining and will continue to do so in 2013, Fahey writes. “Instead of high single digit returns on investment grade corporate bonds and even double-digit returns on high yield and emerging market bonds, investors need to adjust their expectations lower.”

Indeed, investors can expect to see a relatively confined range of returns under LPL Financial’s base, bull and bear case scenarios for 2013, according to LPL Market Strategist Anthony Valeri.

“Due to slow economic growth, European debt concerns, and perhaps most importantly, a very market-friendly Fed, bond prices continued to rise, and yields continued on their downward descent in 2012,” Valeri writes in his fixed income 2013 outlook. “Regardless of the specific outcome of fiscal cliff negotiations, the above three factors will play a role in bond returns in 2013. Along with low yields, this is why we expect a relatively confined range of returns under our base, bull, and bear case scenarios for 2013.”

On the positive side, inflation won’t have much effect on the bond market in the near term, notes Jonathan Mackay, senior fixed income strategist for Morgan Stanley Wealth Management. But the negative, he adds, is that “the fear factor” of European recession will hurt fixed income as debt-laden countries and banks deleverage while investors flee to the relative safety of U.S. Treasuries.

“It’s a very strange environment we’re in, and we will be in it for the foreseeable future,” Mackay says.

Read on to learn more about what analysts from Loomis Sayles, LPL, Morgan Stanley and other financial firms are saying about the outlook for fixed income in 2013.

Yield-Thirsty Investors to See Single Digits

Loomis Sayles’ Fahey says investors’ thirst for yield may be slaked by a number of bond sectors in 2013, but returns will be closer to the yield on the bond when bought and should not incorporate much in the way of bond price inflation.

“Some of our favorite sectors in fixed income that could produce mid single digit returns in 2013 are bank loans, convertible bonds, high yield and RMBS,” Fahey writes in his 2013 fixed income outlook. “We still like the investment grade credit markets in the U.S. and Europe but think emerging market companies that issue in dollars and euros should do better. There is not a lot of value in high quality sovereign bonds such as Treasuries, bunds, or gilts, unless there is some major economic downturn or financial accident which Loomis Sayles doesn’t have in our base case outlook for 2013.”

Fahey says the bull market in bonds will end only when global demand rises to a self-sustaining level generated by consumers and companies willing to borrow, spend, invest and hire. “Unfortunately, at this point, we don’t see that aggressive rise in demand coming in 2013,” he says.

Focus on Munis and Investment-Grade Corporates

Most bond investors fared better in 2012 than the broad market, as economically sensitive sectors outpaced the high-quality Barclays Aggregate Bond Index, writes LPL’s Valeri in a fixed income outlook for next year. In 2013, Valeri’s base case calls for high-quality bonds to yield only low single-digit returns.

“Among high-quality bonds, investment-grade corporate bonds and municipal bonds remain our focus,” Valeri writes in a fixed income 2013 outlook. “With an average yield advantage, or spread, of 1.5% to comparable Treasuries–above the 1.3% long-term average–investment-grade corporate bonds remain attractive and are supported by good credit quality metrics. These two factors help offset average yields that hover near historic lows.”

Hew to the Middle of the Road

Morgan Stanley’sMackay believes credit markets will generate positive returns in 2013, but not near the levels seen over the past four years. The “very strange environment we’re in,” as Mackay phrases it, calls for a “middle-of-the-road” investment approach. In a Credit 2013 Outlook co-written with Chief Fixed Income Strategist Kevin Flanagan, Mackay says: “It isn’t very exciting, but staying with the flow of traffic sure beats getting passed because you’re in the slow lane or getting a ticket in the fast lane.”

Expect rates to remain range bound next year, which should benefit investment grade and high yield credit, say Mackay and Flanagan, “as investors will likely continue to pour money into both asset classes in the hunt for yield.” They see particular value in three- to seven-year IG and two- to five-year BB rated HY, especially in regional banks, insurance, natural gas distribution, electric utilities, and health-care and consumer products.

Fiscal Cliff May Be Kind to Corporates

The rule of thumb is that bonds like bad news because they do well as safe haven investments. And in the case of the looming fiscal cliff in Washington, the longer that lawmakers wait to reach an agreement, the greater the risk of another bout of market volatility, warns BNY Mellon’sStandish Mellon Asset Management Global Macro Strategist Thomas Higgins. Even with an agreement, economic growth will slow and U.S. GDP will fall by about 1.4% in 2013, possibly leading to recession, Higgins says.

The Fed’s commitment to holding rates low with continued quantitative easing “seems likely to continue to push investors out of Treasuries and into riskier assets, including U.S. corporate credit,” Higgins writes in a market insight.

“The silver lining may be that U.S. corporate credit markets have historically weathered low growth environments relatively well,” he says. “Indeed, over the past two decades, both U.S. investment grade and high yield bonds have posted positive excess returns when U.S. economic growth is running between 1% and 2%.”

Don’t Overdo Liquidity

Markets once again climbed “the proverbial wall of worry” after the brief post-election sell-off, notes OppenheimerFunds Chief Economist Jerry Webman, who says that rhetoric will be heated in the days ahead and that a little extra liquidity in an investor’s portfolio could prove useful.

However, holding a little extra liquidity “is not the same thing as selling all your investments in a panic and moving to 100% cash, as I’ve heard a business television anchor claim to be planning,” Webman writes in a comment.

“You wouldn’t take out a $1 million insurance policy on a $500,000 house, and for similar reasons, investors shouldn’t overdo the amount of liquidity they hold in their portfolio,” Webman writes. “While holding extra cash or high quality bonds may be prudent when there’s a clear risk of heightened volatility, such assets won’t help build wealth over the longer term. Remember the cost of holding the extra liquidity is the negative real yield (current yield on 10-year Treasury is 1.62% with the consumer price index up 2.2% over the past year) that cash and government bonds currently offer.”

Focus on Diversification

Wells Fargo Advisors Chief Fixed Income Strategist Brian Rehling says that as low interest rates present challenges in 2013, investors would do well to focus on diversification.

Rehling doesn’t expect a significant increase in interest rates next year, and Wells’ year-end target on the 10-year Treasury yield is 2.50%, he predicts in his 2013 fixed income outlook.

He advises investors to have a good asset allocation plan: “We encourage fixed income investors who need to increase yield within their fixed-income portfolio to do so by adding allocations to credit-sensitive sectors, such as corporate bonds, rather than moving too far out the interest rate curve. Investors with a short investment horizon should use caution in adding to the more credit-sensitive sectors, such as high-yield (junk) bonds and preferred securities given the potentially volatile nature of these sectors.”

Investors should avoid “reaching for yield” in 2013 by moving lower in credit quality than is appropriate for their risk tolerance, Rehling advises.